Normalizing Owner Compensation

When performing a business valuation, I always consider making adjustments to revenue and/or expenses of the business in order to normalize its income statement. These adjustments, among many other valuation techniques, allow me to understand the true economic performance of the business. Owner compensation is one of the most common expenses to be adjusted in performing a business valuation, especially for a closely held business. Why is that?

For closely held businesses, the answer oftentimes lies with discretion. If the business generated excess cash flow, then the owner must decide what to do with the excess cash. Options include rewarding themselves with a bonus, returning capital invested, paying off debt, or using it to fund future operating expenses and/or asset purchases. Alternatively, if the business underperformed, would the owner avoid taking a year-end bonus or even reduce their compensation?

Several years ago, I asked a highly successful business owner why his salary increased from $800,000 in the prior year to over $3,000,000 in the current year. He candidly replied, “Because I run the show.” The owner had no merit-based explanation to justify such a large increase in salary.

I often find myself looking beyond the numbers to understand if, and how, the owner may be controlling or influencing corporate expenses to achieve a specific desired outcome. For example, I’ve come across instances where business owners in pursuit of a bank line of credit have created the illusion of profitability in the business by minimizing their own compensation in order to increase the odds of bank approval. Alternatively, and more frequently, I’ve seen business owners maximize their compensation, sometimes within reason and sometimes not, in order to lower the business’s taxable income thereby generating tax savings for the business and/or its owners. Regardless, when analyzing owner compensation, I always consider business owners’ possible desired outcomes in order to understand the business’s true economic performance.

Once I develop an understanding of how an owner’s compensation is determined, I begin to research market compensation paid to owners of businesses operating in “similar industries” – a term that can be quite subjective. Numerous court cases have considered questions of reasonable compensation for business owners and have identified a variety of qualitative and quantitative factors to be analyzed. These factors vary from court to court, but the factors most often relied on, for this purpose, include the following:

• Owner’s qualifications
• Owner’s contribution to the success of the business
• Salaries paid to other employees of the employer-taxpayer
• Standard industry compensation
• Whether an independent investor would approve the compensation arrangement

Another publication that provides guidance in the area of reasonable compensation for business owners is the Internal Revenue Service’s Reasonable Compensation Job Aid for IRS Valuation Professionals (the IRS Job Aid), which similarly lists many factors recognized by the courts in determining whether compensation is reasonable:

• What is the background and experience of the owner?
• What education, qualifications, certifications or licenses does the owner possess?
• What is the nature, extent and scope of services performed by the owner?
• How much time does the owner devote to the business?
• How responsible is the owner for revenue generation?
• How extensive is the owner’s knowledge of the business?
• What is the supply and demand for the owner’s duties?
• How complex is the business?
• What do the historical earnings of the business look like?
• Is there an employment agreement or formula that sets owner compensation?

Utilizing empirical data that can be found in benchmarking surveys, subscription databases, internet sites, and printed reports or texts allows me to further assess quantitative factors. Specific resources of empirical data include, but are not limited to, CCH’s Almanac of Business and Industrial Financial Ratios, RMA’s Annual Statement Studies, and Robert Half Salary Guides, just to name a few.

At the end of the day, the reasonableness of compensation paid is a question of fact, and each case turns to its own facts and circumstances. If normalizing adjustments to owner compensation and other discretionary expenses are called for but not made, the business in question could be significantly overvalued or undervalued.

Allow me to close with a simple illustration under the market approach, where a valuation analyst has determined 4.5x to be an appropriate enterprise value to earnings before interest, tax, depreciation and amortization (EBITDA) multiple for a subject company.[1]

In this example, the subject company reported an EBITDA of $500,000 in the current year, which included the owner’s compensation expense for $75,000. However, the valuation analyst’s research and analysis indicated $250,000 to be a reasonable amount paid to the subject company’s owner.

	Reported	Normalized	Difference
Subject’s EBITDA	$500,000	$325,000	$175,000
Selected Multiple	4.5x	4.5x
Subject’s Indicated Enterprise Value	$2,250,000	$1,462,500	$787,500

In this illustration, if the valuation analyst did not adjust owner compensation to a reasonable amount, the value of the business would have been overstated by $787,500.

At Aprio, we are here to help your business navigate compensation and valuation matters and empower you to achieve what’s next. Schedule a consultation with an experienced Aprio advisor to discuss your business valuation needs.

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[1] For illustration purposes of this simplified example, the basis of determining the selected multiple as well as other valuation techniques to be considered is beyond the scope of this article.